A collection of often sceptical, always candid observations and insights on the US economy and large-cap equity markets. Readers have observed my style and perspective to be that "the emperor has no clothes," and that is reasonably accurate.
Postings reflect my philosophies and perspectives on economics, business and politics.

Monday, June 15, 2009

Art Laffer Again On the Coming Hyper-Inflation

Last October, shortly before the November election, economist Art Laffer wrote a blistering piece in the Wall Street Journal, on which I wrote this post.

Before knowing of the extensive governmental intervention into autos and, planned, into healthcare, Laffer wrote,

"If you don't believe me, just watch how Congress and Barney Frank run the banks. If you thought they did a bad job running the post office, Amtrak, Fannie Mae, Freddie Mac and the military, just wait till you see what they'll do with Wall Street.

Whenever people make decisions when they are panicked, the consequences are rarely pretty. We are now witnessing the end of prosperity."

In last Wednesday's Journal, Laffer was even more bleak. He wrote,

"Here we stand more than a year into a grave economic crisis with a projected budget deficit of 13% of GDP. That's more than twice the size of the next largest deficit since World War II. And this projected deficit is the culmination of a year when the federal government, at taxpayers' expense, acquired enormous stakes in the banking, auto, mortgage, health-care and insurance industries.

With the crisis, the ill-conceived government reactions, and the ensuing economic downturn, the unfunded liabilities of federal programs -- such as Social Security, civil-service and military pensions, the Pension Benefit Guarantee Corporation, Medicare and Medicaid -- are over the $100 trillion mark. With U.S. GDP and federal tax receipts at about $14 trillion and $2.4 trillion respectively, such a debt all but guarantees higher interest rates, massive tax increases, and partial default on government promises.

But as bad as the fiscal picture is, panic-driven monetary policies portend to have even more dire consequences. We can expect rapidly rising prices and much, much higher interest rates over the next four or five years, and a concomitant deleterious impact on output and employment not unlike the late 1970s.

The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base -- which prior to the expansion had comprised 95% of the monetary base -- has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes!

Alas, I doubt very much that the Fed will do what is necessary to guard against future inflation and higher interest rates. If the Fed were to reduce the monetary base by $1 trillion, it would need to sell a net $1 trillion in bonds. This would put the Fed in direct competition with Treasury's planned issuance of about $2 trillion worth of bonds over the coming 12 months. Failed auctions would become the norm and bond prices would tumble, reflecting a massive oversupply of government bonds.

In addition, a rapid contraction of the monetary base as I propose would cause a contraction in bank lending, or at best limited expansion. This is exactly what happened in 2000 and 2001 when the Fed contracted the monetary base the last time. The economy quickly dipped into recession. While the short-term pain of a deepened recession is quite sharp, the long-term consequences of double-digit inflation are devastating. For Fed Chairman Ben Bernanke it's a Hobson's choice. For me the issue is how to protect assets for my grandchildren."

Laffer's a pretty smart guy. His insights into the likely hyper-inflation dovetail neatly with his October piece. It's hard to see how inflation won't be coming barrelling into the US economy soon. Those who keep saying they are more worried about deflation seem to have forgotten the Carter years.

Given the expanded monetary base, how on earth will inflation not roar ahead, with so many dollars shoved into international portfolios?

Frankly, I'm at a loss as to understand how the equity markets can have risen some 30% in two months or so, with these numbers available for all to see.

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About Me

A well-educated veteran of US corporate strategy positions & hedge fund management, as well as research, product development and project work in consulting, strategy and equity management. Academic background in marketing, strategy, statistics and economics.
Currently own Performance Research Associates, LLC, through which I am involved in proprietary equity and equity options investment management.